Profile of multinational businesses with inbound investments.

• Author: Godfrey, Howard

Growth in international business brings increased opportunities for CPA firms to provide accounting and tax services. Foreign investors expand business operations into the United States with inbound investments, which include buying or organizing U.S. subsidiary corporations, operating U.S. branches, investing in partnerships that have U.S. business operations, and investing in U.S. real estate. U.S. investors may also choose to expand business operations in foreign countries with outbound investments that follow the same patterns. This article focuses on multinational businesses with inbound investments--i.e., foreign investors with business operations in the United States.

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Foreign investment in the United States is significant and is steadily increasing. (1) Over 63,000 U.S. corporations are foreign controlled. Foreign investors also have about 15,000 branches in the United States, and about 8,000 foreign partnerships report U.S. source income on annual U.S. partnership tax returns. (2) The stock of foreign direct investment in the United States increased $197 billion to $2.6 trillion in 2008. (3)

On the outbound side, about 11,000 U.S. corporations have about 75,000 foreign subsidiaries with assets of about $9 trillion and net income of about $362 billion. (4) Individuals reported foreign tax credits on 7.6 million individual tax returns for 2007, claiming foreign tax credits of about $15 billion for foreign income taxes paid on foreign source income. (5) U.S.-owned equity in (and loans to) foreign affiliates reached $3.2 trillion at the end of 2008, an increase of 8% over 2007. (6)

This article presents a profile of the major types of entities engaged in inbound transactions, which involve foreign investment in the United States. Applicable tax laws, tax return filing requirements, and tax planning strategies are explained for each type of multinational business. Clients expanding global business activities will very likely provide new business opportunities for CPAs but may also pose some potential traps and pitfalls to avoid. The United States has tax treaties with over 50 foreign countries with special provisions that may reduce the tax cost of engaging in international business. The global tax perspective and guidelines presented here should be of interest to CPAs with multinational clients.

FCDCs: U.S. Subsidiary with Foreign Owner

In 2007, foreign persons invested $277 billion to acquire interests (7) in U.S. businesses or to start new businesses here. (8) Most of this investment (92%) was for the acquisition of existing U.S. firms. U.S. corporations that have foreign owners are termed foreign-controlled domestic corporations (FCDCs) and have essentially the same requirements for filing corporate income tax returns and paying taxes as other domestic corporations. Substantially all FCDCs file Form 1120, U.S. Corporation Income Tax Return. A few FCDCs file other forms in the 1120 series, such as 1120L, U.S. Life Insurance Company Income Tax Return, for life insurance companies. FCDCs do not file Forms 1120S, U.S. Income Tax Return for an S Corporation, or 1120-F, U.S. Income Tax Return of a Foreign Corporation, which are discussed later in this article. As noted in the next section, FCDCs must also file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, relating to intercompany transactions.

Number and Importance of FCDCs

For tax years ending between July 2006 and June 2007, U.S. corporations that were foreign controlled filed 63,951 corporate income tax returns. (9) These FCDCs had total receipts of $3.8 trillion and assets of $9.7 trillion and paid U.S. income taxes of $50 billion. (10) Of these, 9.3% (5,977) were consolidated returns. (11) This indicates that the number of U.S. corporations under direct or indirect control of foreign persons was substantially larger than 63,951.

About 27% (17,226) of FCDCs filing returns in 2006 were new (incorporated within the last three tax years). 3,948 were large FCDCs (those with receipts of at least $50 million or assets of at least $250 million), and 391 of these large FCDCs were new. (12) (These statistics do not cover corporations that are owned by several foreign persons but where no foreign person owns 50% or more.) (13) FCDCs tended to be large, with average assets totaling about $150 million. On average, FCDCs were over 12 times the size of non-foreign-controlled domestic corporations. The 3,948 large FCDCs accounted for about 95% of the assets and 95% of the receipts of all FCDCs. About one-third of the large FCDCs were in wholesale or retail trades and 37% were manufacturers, but the manufacturers tended to be larger, accounting for almost 52% of the business receipts of all large FCDCs. These subsidiaries often purchased substantial amounts of inventory from their parents in foreign countries. (14)

FCDCs with parents in five countries reported 70% of FCDC receipts. U.K.-owned subsidiaries reported 23% of all FCDC receipts, followed by subsidiaries with owners in Japan (16%), Germany (12%), Canada (9%), and the Netherlands (7%). Although Mexico is a major trading partner with the United States, there were fewer U.S. subsidiaries with parents in Mexico. (15)

Profitability of FCDCs

FCDCs tend to be less profitable than their non-foreign-controlled competitors in the United States. In 2006, 15,293 returns were filed by large non-foreign-controlled corporations, having average retained earnings of $274 million per return. Returns filed by 3,948 large FCDCs showed average retained earnings of $3 million per return. All manufacturing FCDCs reported gross profit rates (16) of 21% of gross receipts, while all non-foreign-controlled manufacturers reported average gross profit rates of 28%, a 7% difference. For companies in wholesale trade, the gross profit rates were 17% for FCDCs and 18% for their non-foreign-controlled counterparts. (17)

Reasons for this difference in profitability have been the subject of many academic studies, which have yielded conflicting results regarding reasons for such differences. For example, one study found no evidence that taxable income declines more after a non-U.S. shareholder acquires a U.S.-domiciled firm than after a U.S. shareholder acquires a U.S.-domiciled firm. (18) Others suggest that the differences may be partly attributable to strategic transfer pricing and tax management.

Form 5472 Reporting Requirements

Role of Intercompany Transactions

The global income tax burden of a parent and a subsidiary corporation can be managed when one entity is in a high-tax (i.e., income tax) country and the other entity is in a low-tax country. For example, a parent corporation (in a low-tax country) may increase the price it charges the subsidiary (in a high-tax country) for inventory. This decreases the amount of income reported in the high-tax country (such as the United States) and increases the amount of income reported in the low-tax country. The global tax liability is reduced as a result of a change in the intercompany pricing policy.

An IRS official has stated that "[t]ransfer pricing that allocates an appropriate return to the U.S. affiliates of multinational groups is a key focus for the IRS."(19) In 2006, the IRS announced a settlement with Glaxo SmithKline Holdings (Americas) Inc. (GSK) over transfer pricing issues for tax years 1989-2005. GSK agreed to pay a record amount of $3.4 billion to the IRS. The government's position was that GSK under- stated its U.S. profits. Transfer pricing issues related to trademarks and other intangibles developed by the company's U.K. parent and the value of GSK's marketing and other contributions in the United States.

Purpose of Form 5472

Congress was concerned about the potential for using intercompany transactions to shift taxable income to other countries. For this reason, it added Sec. 6038A to the Code, requiring extensive recordkeeping...